Category Archives: Eurozone

ECB’s additional dilemma

In December I argued that inflation is too high but that the European Central Bank (ECB) faced a dilemma (link): Raise rates and high-debt countries will suffer, or keep rates low and inflation will remain too high. I concluded that the ECB should start raising rates. Inflation is now even higher, and the ECB faces an additional dilemma: Raise rates and risk derailing a recovery already suffering under the weight of elevated uncertainty and high energy prices, or keep rates low and inflation will remain too high for too long. Another worrying development is that ECB risks losing its grip on inflation expectations. What to do?

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ECB’s dilemma: Choosing between the devil (raise rates) and the deep blue sea (don’t raise rates)

Inflation in the Eurozone is historically high. One would expect that the European Central Bank (the ECB) would only talk about raising rates. Instead, they only talk about keeping rates low, in contrast to other central banks. Why is the ECB so strongly ruling out even the possibility that rates might be raised? Probably because there are highly indebted countries in the Eurozone that would suffer. The ECB is caught in a dilemma: Raise rates and risk that Italy (and other countries) will face debt-servicing challenges or keep rates low and risk that inflation remains too high. What to do?

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It’s this time of the year. This post recalls events of 2020. It has been such an unusual year, so different from what we expected. Luckily, there seems to be light at the end of the very long and dark tunnel, and – I hope – that 2021 will be considerably more joyful than 2020.

2020 started out so well. The roaring twenties and all that. Wuhan was a city I had not heard of, corona a beer people tell me is best served ice-cold with a slice of lime (I do not drink beer, tough I do enjoy wine), and social distancing words we would only get to know too well. Today, we know that Wuhan is a Chinese city with more than eleven million inhabitants and a marketplace where it presumably all started, corona also means something terrible, and social interaction is an activity we have come to miss so dearly.

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Italy vs. Greece

There are similarities between Greece in 2010 and Italy today that make me nervous.

Do you remember the Greek drama in 2010-2012? Following the financial crisis in 2008-2009, Greece saw it public finances deteriorate, as did most other countries. The special thing about Greece was that they had fudged the numbers. In autumn 2009, the new Greek Prime Minister, George A. Papandreou revealed that the former government had lied about the deficit. This, and the recession, brought public debt to 146% of GDP in 2010. It later turned out that Greece had also falsified the numbers – via different swap contracts, willingly helped by US banks – prior to the introduction of the euro, making the whole thing even worse. With debt running at close to 150% of GDP in 2010, investors lost faith. Greek yields skyrocketed (see below). Greece received a number of rescue packages from the EU commission, IMF, and the ECB (the so-called “Troika”). Eventually, in 2012, Greece restructured its debt in the largest sovereign default in history. Investors faced a loss to the tune of EUR 100bn.

Why do I repeat this sad story? Because the IMF Fiscal Monitor Report contained a forecast for Italy that has, in my opinion, not received enough attention. The IMF predicts that Italy will reach a public debt level of 150% of GDP this year, exactly like Greece in 2010. Will this lead to a replay of the European debt drama?

First, the data. We are in the middle of a terrible recession. Italy has been severely affected by the corona virus, and has as a consequence enforced a strict lockdown. IMF expects that Italy will be one of the worst hit countries. Italian GDP is expected to fall by 9.1% during 2020.

IMF also expects that the fiscal deficit will be 8.3% of GDP in 2020. This is a large deficit, but other countries face even larger ones. The US, for instance, 15.4% of GDP (this probably requires another blog post…..), China 11.2%, Spain 9.5%, and so on.

The problem in Italy is that public debt levels are already very high, at 130% of GDP. Few countries match this. In fact, only Japan and Greece. What is noteworthy, in my opinion, is that the combination of the already high debt level, the severe recession, and the fiscal deficit will most likely take the debt level to more than 150% in 2020:

Greek and Italian public debt as a percentage of GDP. Data for 2020 and 2021 are forecasts from the IMF.
Data source: EU Open Data Portal and IMF Fiscal Monitor Report.

The figure superimposes a dotted line indicating the 146% debt-to-GDP level Greece reached in 2010, which sparked the Greek problems. Italy is expected to cross this line in 2020.

Contributing to my concern is the fact that financial markets seem to treat Italy and Greece somewhat similar this time around, in contrast to 2010. This time, movements in the Italian yield spread to Germany largely mirror movements in the Greek yield spread:

Greek and Italian yield spread towards Germany. Ten-year government bonds. Daily data: January 2, 2020 – April 30, 2020.
Data source: Thomos Reuter Datastream via Eikon.

The spread between Greek and German ten-year government bonds is a little higher than the spread between Italian and German government bonds, but movements are very similar. Only between the ECB/Christine Lagarde blunder on March 12 and the introduction of the PEPP (see below) on March 18, there was some divergence between Italian and Greek yields. Otherwise, they have moved in tandem.

This is different from 2010. In 2010, Greek yields spiraled out of control, reaching close to 50% on the worst days, but something like 25% for the worst month on average:

Greek and Italian yield spread towards Germany. Ten-year government bonds. Monthly data: 2000-2020.
Data source: St. Louis Fed.

The Italian spread also increased in 2010, but, back then, markets clearly distinguished between Greece and Italy. Today, markets view Italy and Greece as being in somewhat similar situations. Rating agencies have started to act (Link).

Will we see a repetition of the Greek drama?

The Greek yield spread was close to 50% on the worst days in 2010, and currently we are talking something like 2.5% for Italy, i.e. very far from 50%, though up from 1.5% in the beginning of the year. This is clearly not as bad as in 2010. I thus hope that we will not see a repetition of the Greek story in Italy, but I dare not rule it out.

Let us start with the good news. Yields are lower today than in 2010. In 2010, Italian yields were around 4%. Today, they are around 2%. Hence, if yields stay low, Italy can afford a larger public debt compared to the situation in 2010. Also, everybody is aware that problems in Italy will mean problems for Europe, as I describe below, i.e. everybody wants to avoid such a situation.

On the other hand, the situation could turn to the worse if the recession in Italy will be deeper than the IMF expects, if the Italian political situation takes another turn to the extreme, if political negotiations at the EU level about a recovering plan do not bear fruit, or if some other negative shock occurs. Should some of this happen, Italy might find itself in something like the Greek situation at some point. The situation is fragile, as shown by the widening of spreads and the downgrade of Italy.

Italy is important for the European project. It is a G7 country. It is one of the founders of the EU. The foundation of the euro would be threatened if Italy runs into trouble. It would have global repercussions. At the same time, Italy is probably too big to bail out for the rest of the Eurozone/EU.

Some say that the ECB will make sure that this will not happen. Perhaps, but this is not as obvious as some claim. We get into technical nitty-gritties here, unfortunately, but it is important to understand.

ECB is buying bonds like crazy at the moment, keeping a lid on yields, including Italian. The ECB’s PEPP (Pandemic emergency purchase programme) implies that the ECB will buy public and private securities to the tune of EUR 750bn during 2020. I.e., the PEPP will help keeping Italian yields down.

Furthermore, at the ECB Governing Council meeting Thursday, April 30, it was decided that “The Governing Council will conduct net asset purchases under the PEPP until it judges that the coronavirus crisis phase is over, but in any case until the end of this year” and “The Governing Council is fully prepared to increase the size of the PEPP and adjust its composition, by as much as necessary and for as long as needed”. Hence, the PEPP might last longer than throughout 2020 and accumulate to more than EUR 750 bn.

BUT, the important sentence in the PEPP programme is this one: “For the purchases of public sector securities under the PEPP, the benchmark allocation across jurisdictions will be the capital key of the national central banks. At the same time, purchases will be conducted in a flexible manner. This allows for fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions.” (Link).

This point here is that that ECB cannot – and I repeat cannot – buy unlimited amounts of Italian debt at the moment. The proportion of Italian bonds the ECB can buy (as a proportion of all Eurozone sovereign debt ECB buys) is restricted by the Italian fraction of ECB capital. At the moment, this is, to be very precise, 13.9165%.

It also says that this will be interpreted in a “flexible manner” – and I am sure the ECB will be flexible – but they cannot be too flexible. ECB just cannot buy unlimited amounts of Italian debt under current programmes.

There is an escape clause: OMT (sorry for this soup of abbreviations; ECB, PEPP, OMT,…). OMT is “Outright Monetary Transactions”. OMT allows ECB to buy unlimited amounts of Italian (and other Eurozone) bonds, should this be necessary. But, and this is a big but, only when the relevant country has entered into a program with the European Stability Mechanism (ESM; one more abbreviation…). An ESM program means that the country will face demands with respect to its conduct of fiscal policy; think about the discussions about the role of the Troika in the Greek drama. To some extent, this is a loss of sovereignty. Entering into a program is also a signal that the country cannot handle the situation on its own. This will make it even more difficult to sell bonds on the market. At the moment, Italy very clearly opposes an ESM program. At the end of the day, this however means that ECB cannot buy unlimited amounts of Italian debt should this become necessary. ECB cannot save Italy.

Other people say “look at Japan”. Japan has a public debt of more than 200% of GDP. IMF expects it to reach 252% of GDP in 2020. Yields in Japan are very low, in spite of this massive debt mountain. I.e., Japan shows that you can accumulate lots of public debt without causing yields to rise, some claim. True, but remember that Japan has its own currency and its own central bank. The Japanese central bank can buy all the public debt they want, keeping Japanese yields down. Italy does not have its own central bank and its own currency. The ECB cannot buy unlimited amounts of Italian bonds. Greece is the example that shows that the situation of a Eurozone country is different from the situation of a country with its own currency and central bank.

(Here, I do not want to get into a discussion whether a country with its own currency and central bank faces no limits on the amounts of public debt it can raise, as argued by proponents of the “Modern Monetary Theory”.  Basically, I disagree with that policy implication and think there is a limit, but this is for another day).

So, in the end, if worst comes to worst, ECB cannot save Italy, unless Italy enters into an ESM program. Some kind of political solution at the EU level would be needed. I hope we will not get there. At the moment, we are not, but I dare not rule that we might get there. I will follow the Italian situation.

Eurozone in trouble again, but this time with a new twist

Fear of a new Eurozone debt crisis, similar to the one in 2010-2012, resurfaced in March. Within a week or two, Italian yields more than doubled. Given Italy’s large stock of sovereign debt, nervousness increased. Since then, yields have come down and markets stabilized somewhat. A key difference to the European debt crisis of 2010-2012 is that yields on “safe” assets, like German and US yields, rose, too. What happened and will calm remain?

First, the facts. This figure shows Italian yields (yield on a ten-year sovereign bond), as well as its spread to the German ten-year government bond yield, from the beginning of the year through April 14. The spread to German bonds is larger than the Italian yield itself because German yields are negative (see below).

Yields on Italian ten-year government bond and spread to German.
Data source: Datastream via Thomas Reuters Eikon.

Bond markets were calm in the beginning of the year, only to explode from March 3 through March 18. On March 3, the Italian benchmark yield was one percent. On March 18, it was 2.4 percent. Similarly, the spread to German yields rose. Given the speed of the adjustment, and the size of Italian government debt, this is worrisome. It reminds us of the situation in 2010 where yields on debt from Italy and other southern European countries rose sharply. There are, however, additional ingredients to the story this time.

The worry with Italy is that it will face difficulties remaining solvent if its yields rise. And, given the size of the Italian debt mountain, it will be difficult for the Eurozone to bail out Italy. It is also a story of disastrous communication by the new ECB chief Christine Lagarde, who at the ECB Press conference on March 12 said the by-now famous words “We are not here to close spreads”, meaning ECB will not come to the rescue of Italy. Many of us wonder why Italy has not tried to stabilize its finances since the European debt crisis, but this was not the right time to raise this point. Italy was in the middle of the terrible corona crisis and markets were nervous. The remark of Lagarde should have been saved for another day. Markets tail-spun.

This time around, however, there is an additional element to the story. Something unusual happened in other bond markets. Look at this graph.

Yields on ten-year government bonds from different countries.
Data source: Datastream via Thomas Reuters Eikon.

It shows yields on ten-year sovereign bonds from a number of countries. Italian rates spiked, as mentioned. However, and this is the curios fact, rates of what is typically viewed as safe-haven bonds also rose dramatically.

German yields rose from their low of minus 84 basis points on March 9 to minus 17 basis points on March 19, an increase of more than sixty basis points. The same goes for Danish and Dutch yields. Denmark, the Netherlands, and Germany are Triple-A rated. Even US yields more than doubled, from fifty basis points to 126. A rise of eighty basis points in US yields within a week or so is very dramatic. It is also very different from what we typically see during times of crises. Typically, in crises, investors sell risky assets and buy bonds of safe-haven countries, causing their yields to fall. This did not happen in March. If safe assets lose value during crises, where should investors seek shelter?

So, this is a story about Italy and a reassessment of the credit risk of Italy. But it is more than this because otherwise safe havens saw yield rose, too, exerting an additional upward pressure on Italian yields.

From early March to mid-March, Italian yields rose by almost 150 basis point. The yield spread to Germany “only” rose by 100 basis points. The difference is the rise in German yields.

This BIS Bulleting provides an interesting account of what caused the rise in US yields during early-mid March. They only look at the US, but probably some of the same factors caused the effects in Germany. BIS argues that hedge funds and other levered investors were forced to sell because of margin calls. “Leverage” means that you borrow to invest and “margin calls” means that you have to come up with extra money when the assets you have bought for borrowed money fall in value. So, when you have borrowed a lot to invest (you are highly leveraged), you will face large margin calls. In this case, you have to sell many assets to generate a lot of cash you can pledge as security. If markets function “perfectly”, dealers will be able to absorb the sales and build up inventories. Prices should be unaffected. But if dealers cannot absorb the sales, for instance because dealers are subject to capital requirements and cannot raise capital immediately, then there is nobody out there to buy and prices of bonds fall and yields rise. BIS argues that these events had spillover effects on other types of investors causing them to sell bonds, too. I.e. a lot of investors had to sell, causing such a big effect. In their FSR, IMF is aligned.

More broadly, BIS argues, these events imply that central banks might need to employ different tools from what they have been used to during previous crises (buy bonds from dealers instead of providing liquidity). The events also imply that a different composition of sovereign bond investors (leveraged private investors instead of sovereign wealth funds) could imply different market dynamics during periods of stress.

Where does this all take us? First, I am still worried about Italy. The Italian sovereign debt is huge, and the situation is shaky. Right now, it might look OK. Italian yields are higher than in January and February, i.e. spreads to e.g. Germany have widened, but not by too much, even if the tendencies of the last couple of days might be worrying. Unrest could easily resurface, however. In addition, events in March told us an important lesson about the implications of changes in market structures. If owners of sovereign bonds of safe countries are mainly leveraged private investors, and if dealers cannot absorb large sell-offs, even yields of safe-haven assets might rise during turmoil. This is worrying for investors, as they will then have fewer places to seek shelter during times of stress.

So, Italian yields rose because investors repriced credit risk in Italy and ECB made a blunder. Spreads to Germany rose. But, Italian yields also rose because yields on safe assets (German and US) rose, pushing up all yields. The latter effect is new, and somewhat scary.